Are the Dominoes Falling? The Impact of Higher Interest Rates on U.S. Banks

Stock markets have rallied strongly in 2023, but returns across sectors are not equal. Banks are underperforming both the broad market as well as other financial services subsectors. One of the reasons behind the underperformance was the Federal Reserve’s (Fed) decision to keep rates artificially low — and then abruptly deciding to end that policy as it admitted that inflation was no longer “transitory.” The uptick in the federal funds rate has translated into higher borrowing costs and reduced demand for loans. And while other institutions were raising savings rates to attract deposits, many banks left their rates near zero and lost deposits.

By keeping the Federal Funds rate near zero for two years and then raising it 525 basis points in 16 months, the Fed’s campaign to quell inflation caused turmoil in the U.S. banking community. Consumers and businesses are moving assets away from U.S. banks as they search for higher-yielding deposit options, while tightened standards are sending borrowers elsewhere for their loan needs.

The yield on the benchmark 10-year Treasury is at its highest in over ten years — and global policymakers have suggested that higher rates are here to stay until inflation returns to central banks’ stated goals.

Higher borrowing costs threaten to push interest payments on the staggering U.S. federal deficit higher, as these debts come due in the next few years. The government’s maturity schedule has approximately 30% of the current $32 trillion debt maturing in 2023. Of that figure, about 12% is long-term debt, which will need to be refinanced at the current higher market rates, from 1.3% to 3.6%. Per the St. Louis Fed, this represents an increase of 0.37% of total GDP, “This 0.37% increase, while seemingly small, equates to about $98 billion more paid on interest.”

While ordinarily higher interest rates are a boon for banks, this time is different — and the “new normal” could have seismic effects on the sector.

With interest rates rising, U.S. banks should be experiencing increased savings deposits. Instead, banks have witnessed record declines over the past several quarters, which in turn is hampering loan growth.

According to data from the Federal Deposit Insurance Corporation (FDIC), total deposits declined by $472 billion from Q4 2022 to Q1 2023, representing the largest reduction in the report’s history.

While some deposits may have moved due to heightened awareness of FDIC insurance limits of $250,000 following the failure of regional banks in the spring, alternative savings options were also a factor. As many banks kept savings rates near zero, banks lost savings deposits to higher-yielding options, including online savings accounts, money market funds, and CDs paying 5% and higher. In fact, the most recent Federal Reserve Beige Book noted, “Some banks reported declines in deposits as customers moved funds to higher yield products.”

The impact of this has impacted international banks as well. UK households withdrew £4.6 billion ($18.5 billion) from banks in May, the highest amount since the Bank of England started tracking monthly outflows in 1997.

The Fed’s actions have also slowed loan demand for U.S. banks.

A recent quarterly survey used by the Fed to assess the credit and lending landscape indicated that banks reported weaker demand and tighter standards for commercial and industrial loans for all-size firms, as well as tightened standards for household loans during the first quarter.

When asked about expectations for changes in lending standards, banks reported continued tightening standards across loan categories for the remainder of 2023, citing “an expected reduction in risk tolerance, an expected deterioration in their liquidity position, increased concerns about funding costs and deposit outflows, as well as increased concerns about the effects of legislative, supervisory, or accounting changes as reasons for expecting further tightening.”

Higher rates have also led to increased worries about defaults, prompting some of the country’s largest banks to set aside billions for loan losses. JPMorgan Chase alone set aside $2.9 billion in provisions in Q2 2023; in total, FactSet estimates provisions for loan losses grew to $9.9 billion in the second quarter.

Also at stake is banks’ exposure to the multi-trillion commercial real estate market. With many firms switching to hybrid or remote work arrangements, office vacancies have steadily grown, property values are declining — leading to an increase in defaults and foreclosures — and more bad news for U.S. banks.

Higher interest rates and less willing lenders are also pushing down mortgage origination rates.

Adding to the woes for the sector is the prospect of regulations requiring increased capital. In response to the failures of Signature Bank, Silicon Valley Bank, and First Republic, the Fed, the FDIC and the Office of the Comptroller of the Currency published a 1,000+ page proposal in late July. The proposal would require an overhaul of risk assessment for “large banking organizations and banking organizations with significant trading activity.” Instead of using internal risk measurement models, banks would reassess how they gauge their riskiness, specifically for bank lending, trading activities, and internal operations.

Banks with over $100 billion in assets would face a 16% hike in capital requirements as part of the continuing interpretation of the international framework as outlined by the Basel Committee on Banking Supervision. As part of the Basel Committee, the United States implements their own interpretation of the guidelines. The increased requirements will force banks to commit more capital to reserves in lieu of repurchasing shares or paying dividends. The proposal is currently open to the public for comments through November 30, 2023, and will likely take up to three years to fully implement.

Following the 2008 financial crisis, regulators established testing to assess the capital ratio of U.S. banks under various hypothetical economic conditions. They are conducted annually, and given the regional bank failures in 2023, this year’s results were carefully watched. The country’s 23 largest banks were deemed able to withstand a severe recession. However, regulators did see some weakness in midsize and regional banks, or Category IV banks. Following the results, regulators communicated private “matters requiring attention” or “matters requiring immediate attention” alerts to several regional banks regarding their liquidity and capital, as well as their compliance and technology functions. Following receipt of these warnings, a board-level reply with a corrective action timeline is mandated.

Declining deposits, tighter lending standards, and the threat of increased capital requirements have led to a wave of downgrades and warnings for U.S. banks from the major credit rating agencies.

Fitch Ratings lowered its assessment of the banking industry’s health in June, and in an interview, analyst Christopher Wolfe indicated that another downgrade of the sector would force the rating firm to reevaluate ratings on over 70 banks, including JPMorgan Chase.

Then, in early August, Moody's downgraded the debt of 10 small and midsize American banks and also put several other banks under review, citing higher funding costs and rising risks due to commercial real estate holdings. Following the announcements by Moody’s and Fitch Ratings, S&P Global Ratings also issued downgrades for several banks, noting depositors moving assets into higher interest-bearing accounts.

The downgrades have pressured stock prices and pushed up bond yields for banks, which will likely lead to further increases in lending standards for borrowers.

One of the beneficiaries of the recent banking upheaval has been private credit funds, considered one of the fastest-growing lending areas. Private credit was chipping away at traditional lending before banking woes surfaced this year. Assets under management for private credit exceeded $1 trillion at the beginning of 2022, and increased capital requirements for banks are expected to provide further tailwinds to this market.

Stressors are causing U.S. banks to underperform, lose deposits, and increase loan loss provisions. Alternative strategies, such as private credit, may provide an opportunity for diversification and return potential, however, their opaqueness presents additional risk and complexities. Crystal Capital Partners offers financial advisors and their clients the opportunity to participate in funds active in the private credit space, including direct lending, distressed credit, opportunistic/ special situations, and specialty finance.